In the 16th century gold & silver started arriving in Europe from the Americas, and was minted into coins. The subsequent increase in inflation led to an understanding that an increase in the money supply results in increased inflation. These days we call that view the Quantity Theory of Money, which states that the quantity of money is directly proportional to price levels, and so if money supply doubles then the price of goods & services doubles.

Unfortunately, things are not quite that simple.

Important formula! MV=PY

I try minimise the use of formulae in my writeups, as I know that maximises the chances of them being read! But this one is important, so here goes:

M.V = P.Y (the Money Supply multiplied by the velocity of circulation = total spending, so if an economy has R10 and the R10 is spent 5 times in a month, the total spending for the month would be R50)

Where M is the nominal money supply

V is the velocity of circulation (how often money changes hands)

P is the average price level

Y is the number of transactions.

Note that MV=PY is not a theory, but an accounting truth. The Quantity Theory of Money assumes that V and Y are constant over the period. However, in particular the assumption that V is constant has been criticised, as it depends on consumer & business spending impulses.

Quantitative Easing

Following the subprime crisis, and the failure of Lehman Brothers in 2008, credit conditions tightened and central banks cut interest rates close to 0%. However the velocity of money was plummeting, and the US Federal Reserve was concerned about the risk of deflation.

So, to further increase the money supply the US Federal Reserve started purchasing assets (mainly bonds) – this has generally been referred to as “quantitative easing”.

Looking at the US Fed in particular, it has twin mandates of maximum employment and price stability:

For price stability the Fed targets 2% inflation. Why not 0%? Well, the Fed argues that this would mean that there’d occasionally be deflation, which it wants to avoid (deflation leads people to hold back on spending as goods will be cheaper tomorrow).

The Fed would like to see unemployment between 5.2% and 6%. Why not 0%? The Fed believes that unemployment below that level may lead to salaries surging and higher inflation.

The United States Fed has seen its balance sheet grow from $1 trillion in 2007 before the financial crisis to $4 trillion in 2014. Over 2014 the Fed has slowed the rate of expansion of its balance sheet:

In December 2013 it reduced monthly asset purchases from $85bn to $75bn.

In January 2014 asset purchases were decreased to $65bn per month.

In March 2014 asset purchases decreased to $55bn per month.

In April 2014 asset purchases decreased to $45bn per month.

In July 2014 asset purchases decreased to $35bn per month.

Might drop to 0 in October 2014?

However, even when asset purchases fall to $0, the Fed will continue reinvesting billions of dollars of maturing securities to maintain the size of its portfolio. The next step after that would be to stop reinvesting.

Note the large shift upwards and then downwards in real asset prices in the graph above. I think the Bank of England was referring mostly to the bond markets, but the impact of quantitative easing has seeped into the pricing of other asset classes.

Why has quantitative easing not led to inflation?

With US unemployment above 8%, there was a lot of slack in the economy. Most of the money the Fed spent on purchasing assets ended up as idle bank reserves on account with the Fed (not part of money supply). Banks were lending less because they’d made lending criteria more stringent, and demand for loans was down. Even so there was still a large increase in the money supply at a time of low GDP growth. Why didn’t this lead to inflation? Well, the velocity of the money supply slowed down considerably:

With low interest rates, the opportunity cost of holding cash was lower.

With economic uncertainty, people were holding & even hoarding more cash than usual.

Of course if velocity of money circulation picks up and banks pick up the pace of lending quicker than the Fed reverses its positions, we will see inflation pick up. Will this happen? Let’s just say that historically central banks are often behind the curve in tightening up monetary policy, and so this risk should not be ignored.

On the other hand I read that Ben Bernanke says we wont see much higher rates in his LIFETIME! Never consensus in economics 🙂

Business Cycles v Financial Cycles

“Business cycles play out over no more than 8 years. Financial cycles that can end in banking crises such as the recent one last much longer than business cycles. Irregular as they may be, they tend to play out over perhaps 15 to 20 years on average. Financial cycles can go largely undetected. They are simply too slow-moving for policymakers whose attention is focused on shorter-term output fluctuations. Balance sheet recessions levy a much heavier toll than normal recessions. Debt accumulation over successive business and financial cycles becomes the decisive factor.”

Banks want to repair their balance sheets, so are reluctant to lend if asset quality is poor and capital is meagre. To avoid recognising losses, banks may continue lending to derelict borrowers.

The indebted will wish to reduce their debt, so if fiscal policy gives them a Rand they’ll choose to save rather than spend it. If monetary policy reduces rates they’ll still pay down their debts rather than spend.

Note that the longest measure of the level of the market is the CAPE ratio (Cylically Adjusted Price to Earnings ratio), which is calculated over 10 years of earnings – therefore it doesn’t cover the full financial cycle.

The Balancing Act going Forward

Monetary policy has barely begun its normalisation process after so many years of “extraordinary accommodation” (central banks have never pushed this hard before!). The Fed is going to unwind its positions, but it wont want to do it:

Too quickly as this may result in deflation.

Too slowly as this may result in inflation.

Inflation is probably the bigger risk, because:

as soon as banks start using their massive reserves to make loans the money supply can grow very quickly.

If the velocity of money increases at the same time, this would push inflation up even more.

Whilst the Fed will try avoid inflation, it hasn’t got experience at unwinding a balance sheet as large as theirs, so is learning on the fly.

The 246 page 84th Annual Report from the Bank for International Settlements is worth a read (period 1 April 2013 to 31 March 2014). According to the report, “central banks need to pay special attention to the risks of exiting too late and too gradually…past experience indicates that huge financial and political economy pressures will be pushing to delay and stretch out the exit

“Credit and property prices have generally continued to rise post-crisis,…In crisis-hit economies, private sector credit expansion has been slow, but debt-to-GDP ratios generally remain high, even if they have come down in some countries…Globally, the total debt of private non-financial sectors has risen by some 30% since the crisis.”

Irrational Euphoria?

“In advanced economies, a powerful and pervasive search for yield has gathered pace and credit spreads have narrowed. The euro area periphery has been no exception. Equity markets have pushed higher.”

“By mid-2014, investors again exhibited strong risk-taking in their search for yield: most emerging market economies stabilised, global equity markets reached new highs and credit spreads continued to narrow. Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally.”

“Corporations in emerging market economies are raising much of their funding from international markets and thus are facing the risk that their funding may evaporate at the first sign of trouble.”

“In crisis-hit economies, fiscal deficits ballooned as revenues collapsed…Debt-to-GDP ratios have risen further; in several cases, they appear to be on an unsustainable path. In countries that were not hit by the crisis, the picture is more mixed with debt:GDP ratios in some cases actually falling, in others rising but from much lower levels. The combined public sector debt of the G7 economies has grown by close to 40%, to some 120% of GDP in the post crisis period – a key factor behind the 20% rise in total debt:GDP ratios globally.” A risk is that a normal business cycle recession hits, at a time when there is very little room for macroeconomic policy to assist.

“many banks face lingering balance sheet weaknesses from direct exposure to overindebted borrowers, the drag of debt overhang on economic recovery and the risk of a slowdown in those countries that are at late stages of financial booms”

And then there’s my personal favourite indicator of whether US markets face a slowdown. Berkshire Hathaway’s book value has underperformed the S&P500 over the last 5 years, the first time this has happened under Buffett’s stewardship. I reckon Buffett will catch up, which would mean that US markets will probably slow down, as Berkshire typically outperforms when the S&P500 has lower growth rates.

“Extraordinarily easy monetary conditions in advanced economies have spread to the rest of the world, encouraging financial booms there. They have done so directly, because currencies are used well beyond the borders of the country of issue. In particular, there is some $7 trillion in dollar-denominated credit outside the United States, and it has been growing strongly post-crisis. Authorities in countries not hit by the credit crisis have found it hard to operate with interest rates that are significantly higher than those in the large crisis-hit jurisdictions for fear of exchange rate overshooting and of attracting surges in capital flows. As a result, for the world as a whole monetary policy has been extraordinarily accommodative for unusually long.”

“Markets have become highly responsive to any signs of an eventual reversal of low interest rates and quantitative easing.”

South Africa : a mild case of stagflation

For investment decisions we don’t get caught up in South Africans’ favourite game of identifying government mistakes and what policy responses should be, but rather we focus on the dispassionate realpolitik. When we move out of the investor frame of mind we can again indulge in our rights as citizens to complain or applaud! Where is South Africa at the moment? For 2 contradicting views (don’t you just love economists & how they always agree with each other!) read:

Rising inflation is particularly a risk in South Africa, as a result of the massive depreciation of the Rand and the high wage demands of workers. Read the statement from the Reserve Bank’s Monetary Policy Committee on 22 May 2014:

Inflation is expected to peak in the 4th quarter of 2014 at 6.5% before dropping to 5.8% in 2015 and 5.5% in 2016 (5.4% in the final quarter of 2016).

“risks to the inflation outlook remain skewed to the upside.” The exchange rate has weakened a lot over the last couple of years. Will it weaken more? Current account deficits will play a role, as will movements in international (e.g. US) interest rates and relative productivity levels.

The domestic growth outlook has deteriorated dramatically and it’s open to debate whether the weak Rand and salary inflation will outweigh the impact of weak domestic growth. Domestic growth is constrained by the lack of electricity generation capacity, and it’s likely that the shortfall will result in blackouts rather than increases in electricity prices to curb demand – but this will still result in an inflation in the cost of electricity, as firms resort to expensive backup generator systems and UPS to ensure continued supply of electricity. The blackouts also result in a decrease in productivity when backup systems fail.

South Africa has a massive level of unemployment, which should theoretically allow interest rates to be low without it impacting on salary inflation. Unfortunately, this possibility is ruled out by union demands for massive salary increases, and so even with the slack in the labour market, salary inflation is a given contributor to general price inflation.

Consider that in normal conditions a 5.4% inflation rate requires short-term rates of about 8.4% (3% higher) to prevent it from increasing further. At the moment the repo rate in South Africa is 5.5%, meaning that the real value of money falls if you invest in the money market (even for tax free investors), and thus encouraging consumption over saving.

Growth in commodity exporting countries is vulnerable to a slowdown in China and lower commodity prices. China has been home to an outsize financial boom, thus raising the probability of a financial recession.

If interest rates in the US rise to combat inflation, the ZAR will probably depreciate against the USD; requiring South Africa to further increase interest rates to avoid inflation.

At the moment South Africa has a mild case of stagflation – low growth & a bit more inflation than we’d like. In fact growth is even lower than it looks, as most of the growth since 2007 has been fuelled by ballooning government debt, which increased from 28% to 47%. With its negative real rates of interest, strong salary inflation, current account deficit and weak Rand, there is a significant risk of SA moving onto the miserable trajectory of low growth and high inflation. As the monetary policy committee puts it: “The committee continues to hold the view that we are in a rising interest rate cycle, and interest rates will have to be normalised in due course. We embarked on this process with our first move in January 2014. At this stage the pace and timing of normalisation in the advanced economies appears to have been pushed out further and may be more moderate than previously believed. We are also aware that this can change very quickly.”